Ritika Janiya
An FTSE 250 water company, Pennon Group, yields an attractive 7.4% dividend, but is this too good to be the case? No competition and a needed service, it seems stable, yet fines and regulatory pressures have forced its stock price down by 44%. Could this stock be a hidden gem or a risky bet?
Pennon Group is one of the major participants in the UK water utility space. It has a reliable dividend and a stable business model. At a 7.4% dividend yield, it may at first glance appear as quite an opportunity for investors seeking passive income. A 44% drop in the stock price since 2019, however, does beg some serious questions.
A Solid Business Model with Challenges
At first glance, the business of Pennon Group looks solid. It’s a water utility company with no direct competitors and providing a service that is essential to everyday living. For this reason, utility stocks, like Pennon, are oftentimes categorized as relatively secure investments. However, recent events have shown that even such businesses can be subject to big problems.
Only earlier this year, Pennon Group shocked many investors by announcing a cut in its final dividend. It later materialized that the reason was the hefty £2.2 million fine for illegally dumping sewage into rivers. Although this fine may seem modest for a company the size of Pennon, it was sufficient to trigger concerns about the state of its finances.
Dividend Cuts: A Sign of Trouble?
Even after the fine, Pennon still managed to edge up its final dividend from 29.77p per share in 2022 to 30.33p per share in 2023. The rise did little to calm investors’ nerves. The company has faced further fines, which have also included a £3.5 million fine for an outbreak of cryptosporidium, and the waterborne parasite could go on to have further implications for its dividend payout in the years to come.
Dividend cuts and fines are not what most investors want to hear, as they seek steady income from their portfolios. An approximation of the current yield of 7.4% might seem quite attractive, but it is worthwhile to consider the sustainability of this with the ongoing changes in regulation.
Regulatory Pressures: A Looming Threat
Probably the most significant threat that might face Pennon Group is rising regulatory pressure. There has been a lot of change recently in the UK’s political scene, and a change in government may bring stricter sanctions against water companies. Labour has made no bones about the fact that it wants to crack down on environmental offenses relating to sewage disposal—exactly the reasons Pennon was fined last year.
If Labour wins the next election, it could mean more significant fines and stricter regulations for companies like Pennon. Again, this is not a one-time concern that is going to fade away but could be long term, continually impacting the profitability of the company and, by extension, the ability to pay dividends.
Water Bills and Revenue Concerns
Another challenge that Pennon Group faces is the regulation of the water bills. Unlike companies that operate in competitive markets, Pennon cannot charge customers as it wishes. Its pricing is determined and controlled by Ofwat, the UK water regulator. This, therefore, sets a ceiling on the probability that Pennon will ever increase revenues when costs go up.
Earlier this year, the group’s subsidiary, South West Water, called for a 33% rise in water bills by 2030. Ofwat, however, sanctioned an increase of 13%. Missing this target is likely to add further pressure on Pennon to make up the shortfall, especially with respect to investments in infrastructure.
It could borrow more money, but that is a risky move with so much debt already on the balance sheet. Otherwise, it would be cutting the dividend further, and that would likely just inflame investors even more.
Short Sellers’ Interest
With all these pressures in play, it’s not such a surprise that Pennon Group has become an area of interest among short sellers: that group of investors who bet that the price of a stock is going to go down. Short sellers like situations where company profitability is under pressure, as Pennon does at the moment. Squeezed on revenue upside by Ofwat and potentially ratcheting up the related costs with government action, the outlook for Pennon’s stock price and dividend yield looks poor.
A Risky Proposition?
Although the high yield of Pennon Group may seem attractive for any income-seeking investor, it is clearly riddled with risks. Challenges range from regulatory pressures to financial penalties, which may further weigh down on its stock price and dividends.
The question for investors, therefore, is whether these risks are worth the potential reward. The 7.4% dividend yield might be tantalizing, but ongoing problems make Pennon a dicey bet. Investors have to be cautious about the balance of potential passive income through this stock and the large uncertainties that lie ahead.
In investing, it’s important to look beyond the veneer. While Pennon Group may offer a high yield, the underlying issues could mean this stock is just too risky.
